May 02, 2007

Accounting for TFP differences across countries

We know that a large part (half or more) of the difference in incomes per head between rich and poor countries is due to differences in total factor productivity (TFP)--i.e., the efficiency with which capital, skills, labor, and other inputs are transformed into final output--with the rest being due to differences in physical or human capital levels. But what accounts for these TFP differences? A new paper by Chang-Tai Hsieh and Peter Klenow takes us some way into understanding the issues:

We use plant-level data from the Chinese Industrial Microdata (1998-2005), the Indian Annual Survey of Industries (1987-1994) and the U.S. Census of Manufacturing (1977, 1987, 1997) to measure dispersion in the marginal products of capital and labor within individual 4-digit manufacturing sectors in each country. We then measure how much aggregate manufacturing output in China and India would increase if capital and labor were to be reallocated to equalize marginal products across plants within each 4-digit sector to the extent observed in the U.S. The U.S. is a critical benchmark for us, as there may be measurement error and factors omitted from the model (such as adjustment costs and markup variation) that generate gaps in marginal products even in a comparatively undistorted country such as the U.S. We find that moving to “U.S. efficiency” would increase TFP by 30-45% in China and 40-50% in India. The output gains would be roughly twice as large if capital accumulated in response to aggregate TFP gains.

In other words, dispersion in TFP across plants within industries is an important source of the productivity gap across countries. This is a hopeful message insofar as it suggests that poor countries are able to sustain economic activities that are much higher-productivity than what their income levels would suggest and that a lot of economic catchup involves catching up with the productivity frontier within their economies.

But the interpretation of these large TFP differences across plants within the same 4-digit industries is still up for grabs. Is it that credit constraints or political connections prevent more productive plants from expanding, and therefore block economy-wide convergence? Or is what we are observing an inherent sign of economic progress, with resources dynamically being reallocated from low- to high-productivity activities, and in which case these gaps are necessary to sustain growth in transition? UPDATE: Link to paper is now fixed.

Not to plug the same book as my last comment, but The Power of Productivity summarizes McKinsey's study of individual sectors in, among others, India and the US (China is unfortunately omitted). Especially, "poor countries are able to sustain economic activities that are much higher-productivity than what their income levels would suggest and that a lot of economic catchup involves catching up with the productivity frontier within their economies" is one of the book's specific conclusions. The difference in TFP is far and away the most important difference between countries, as the title of the book implies. What causes the difference? As you say "Is it that credit constraints or political connections prevent more productive plants from expanding, and therefore block economy-wide convergence?" It's different for every country and every industry, but they find that it's almost always tied to counter-productive regulatory rules that prevent competition from working itself out. E.g., Japan's land rules allow unproductive mom & pop stores to sustain themselves; Europe prevented car imports and thus their auto industry lags/lagged. And yet, Brazil, with all its regulatory problems, can have world class airplane manufacturing, because that sector is well-regulated.

As an economics student I'd hoped to find big-picture solutions to the big-picture problems of development, but that book made me realize the scope of the problem -- getting a million little details right -- that broad-based development requires.

'Coming to REER, the overvalued rupee should not be causing any concern or fear. It is clear that REER represents economy’s health, even if we think that it is not cause of the health of economy. In case of China too, its is getting stronger. So in simple terms REER values would succeed economic efficiency of the country because being efficient is not due to exchange rate but is due to open economic policy, market mechanism and just rules and taxes. In fact, all this happened in India and now the benefits are flowing. Did stronger dollar, when it was strong, ever worried USA or there is any extraordinary worry there for the Euro’s higher value. I hope that RBI also learns in the new dispensation and stops crying wolf every now and then.' this is part of a post on www.krsnakhandelwal.wordpress.com in April 07

I have two interpretations for the TFP differences
1. blame the poor: there are country-specific and industry-specific policies that restrict the technologies and organizational forms that are used.
2. blame the rich: the licensing costs of the efficient technologies are too high.

I don't think realizing "maximum" technical efficiency is ever a matter of just applying the right technology in the right organizational form. (The production function is a seriously bad analysis of production.)

Organizations (industries, firms, plants) are emergent, and embed "technology" as they learn or develop it. The processes by which an organization acquires and develops a high level of technical efficiency are just that, processes, which occur in real time. The old adage that nine women cannot make a baby in a month applies.

An organization learns a high-level of total factor productivity, in a process in which a lot of small, local changes or adaptations are made.

This process of organizational learning, like the learning and growth of a child, can be aided by schooling, but experience is also indispensible, and the organic development of the child can not be rushed beyond some limit.

To a large extent, advancing total factor productivity is a matter of creating more effective systems of control, at all levels -- professional, plant, firm, industry, market, infrastructure. Schemes of informational modeling and feedback -- social systems that define, measure and highlight errors, and reward progressive reform of organization can become critical.

I was in Thailand a few months ago, and it is easy to see that vast resources are not yet participating in that country's advanced sectors. But, everywhere, you see the obsession with formal schooling, of individuals and organizations. Many large organizations proudly display their ISO 900x certifications, as an example. So, schooling is going on. But, there must also be learning by doing -- you cannot become a high-productivity manufacturing plant without making stuff, including mistakes, and learning from it. All learning comes down to learning from mistakes, and so, mistakes must be made, which implies that a lower level of technical efficiency necessarily precedes a higher level.

Dispersion of total factor productivity across an industry should be interpreted in a framework, which is aware of rents, and their role in creating a way to capture the sunk cost investments being made advancing technical efficiency.

Dispersion is a normal feature of industry structure, even in advanced countries, for a variety of reasons. For example, because economies of internal scale apply, larger firms may be absolutely more efficient, but, for other reasons, the size of firms tends to skew. For every Coke, there's a Pepsi; for every Hertz, an Avis, and so on.

The high proportion of sunk cost investment, which figures in the technical efficiency achieved in an advanced industry, also means that less efficient firms are protected, to some extent, by the margin of quasi-rents being earned. So, at some stage of development the pace of long-run changes in market share may slow to a glacial pace, leaving a skew of firm size and technical efficiency to persist in an apparent permanency.

Smaller firms in an industry, however, are often forced to consider high-risk strategies, and so, may be the ones to spur innovation and change. In that case, the dispersion is necessary to insure disparate trials continue. In a catch-up frame, it may be too easy to ignore the potential importance of disparate trials -- of having some firms zig while others zag, in trying to find ways to develop successfully.

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Most of the growth accounting literature relies on an aggregate production function to determine the contribution of factors of production relative to that of total factor productivity (TFP) in explaining differences in incomes across countries.

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